Japan in an Institutional Quagmire: Political Economy of the Banking Crisis and International Business

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Preliminary draft:

for discussion purpose only

March 14, 2002

Japan in an Institutional Quagmire: Political Economy of

the Banking Crisis and International Business

Terutomo Ozawa

Professor of Economics

Department of Economics

Colorado State University

Fort Collins, CO. 80523-1771

Phone: (970) 491-6075

Fax: (970) 491-2925


Paper presented at the 3rd Annual International Business Research


organized by and held at the Fox School of Business and Management,

Temple University, Philadelphia, March 22-23, 2002

Japan in an Institutional Quagmire: Political Economy of the Banking Crisis

and International Business

Terutomo Ozawa


When we talk about “institutions and international business,” it is important to keep in mind that there are two layers of institutional setting: one is an “outer” set of global institutional setups and the other is an “inner” set of domestic institutional arrangements in individual countries. Both sets evolve as their surrounding politico-economic conditions alter over time. In this age of globalization the outer set is dominant over the inner set, often forcing accommodation and compliance of the latter with the norms of the former. Most of the times, international business activities are reacting and adapting to their institutional frameworks but they themselves are increasingly becoming the agents of institutional homogenization throughout the world.

As stressed by Douglas North (1990), the overall economic performance of a given economic unit is largely determined (enhanced or retarded ) by an institutional regime. Such a regime can also be called “an institutional matrix that defines the incentive structure of society” against the backdrop of “the belief system” that connects “reality” to the institutions (emphases added, North, 1999, p. 9). And the belief system is a product of local mores and traditions in the individual countries. North was thus talking about the role of an institutional matrix in a given individual country—that is, an inner set. In contrast, however, the outer set (a global institutional matrix) is based on the belief system of a prevailing hegemon. That is to say, at the moment (especially after the collapse of the Soviet Union) the Pax Americana rules the world with the ideology of global capitalism embedded in the Anglo-Saxon belief system. Since the outer and inner sets are thus molded by their respectively different belief systems, conflicts and tensions are naturally expected to arise. Moreover, as stressed by Gerschenkron (1962), developing countries, as late-comers to industrialization, tend to become more reliant on institutional arrangements rather than the market—for the very simple reason that the market mechanism has not yet been well developed. And in the early postwar period Japan was still a “newly industrializing” economy in many ways. It is in terms of “political economy/institutional economics” that the postwar—and current--experience of Japan is interpreted and explored in this paper.

Japan’s postwar economy is well known for a number of unique characteristics such as state-controlled bank-based finance, the main bank system, keiretsu, company unions, lifetime employment, consensus decision-making, and the seniority system of promotion and wages (although these peculiar characteristics once considered inveterate have lately begun to change). And Japanese society has been disposed to collective welfare-maximization with equitable income distribution rather than individualistic (self-interest) welfare-maximization. All these features constitute an inner set of interwoven institutions. And each of them has already been exhaustively examined by many scholars from a variety of perspectives and in great detail. But they have so far been studied separately and not as a coherent system of interdependent institutions (Ozawa, 2001a). Less known and left unexplored, moreover, is another important organizational setup, a so-called “dual industrial structure.” This paper focuses on this particular setup, though references to other related institutions are also made whenever appropriate.

The leitmotif of this study is as follows: (i) that the origin of Japan’s dual structure had a lot to do with the outer set of global institutional arrangements in the early postwar period (especially, the Allies’ occupation policy which was adopted in the wake of communist threat), (ii) that Japan’s pre-crisis phenomenal growth was built on this unique inner set of institutions, (iii) that Japan’s present predicaments and its slow pace of reform is largely explainable in terms of the politico-economic difficulties associated with the dismantling of its postwar—now obsolete--internal structure, but (iv) that the new forces of globalization (i.e., stepped-up international business activities) which originate in the outer set are currently compelling Japan to renovate its domestic institutions—that is to say, the only way out of its present imbroglio is to adapt more closely, if not totally, to the norms of the newly emerged outer set of institutions.

The Outer Set of Global Institutions in Evolution

Early postwar Japan was serendipitously able to take advantage of a favorable external economic environment. At war’s end, the Allied Forces planned to strip industrial machinery and equipment off Japanese factories and ship them out as war reparations to other Asian nations which suffered Japanese occupation. Japan was supposed to revert to an agrarian subsistence economy devoid of industrial capability to wage another war. With the start of the Cold War, however, this radical punishment plan was quickly scrapped, and the U.S. began to assist Japan in reconstructing itself as a bastion against communism. Communists’ takeover of China in 1949 and the resultant Sino-Soviet Alliance was taken as a big threat to the Free World.3 And the U.S. immediately began to wage “economic cold war” (“negative economic diplomacy” or “economic embargo”) (Zhang, 2001) against the communist bloc—and at the same time, “positive economic diplomacy” to the U.S. allies. This diplomacy was designed to ensure Asia’s “continuous orientation toward Washington” (Cumings, 1984). And the Korean War was clearly a god-send blessing for the Japanese economy. It kick-started the reconstruction and modernization of Japan’s heavy and chemical industries.

On the political front, as detailed below, a conservative government was soon assisted to be established, and agriculture in particular was restructured in such a way to serve as a powerful support base for a pro-business (pro-America) political party, the Liberal Democratic Party which would preside over Japan for the subsequent four decades of rapid growth. Furthermore, the U.S. tolerated Japan’s protectionist infant-industry catch-up strategy and even willingly provided technology and market access—all in the name of fighting against communism at the cost of America’s economic interests.

A stable monetary system was established in the form of the Bretton Woods regime of pegged exchange rates. It also gave Japan temporary immunity to capital and foreign exchange controls. At the time of entry to the IMF in 1949, the Japanese yen was on the whole set at a somewhat undervalued rate in favor of Japanese exports and continued to be increasingly undervalued as Japanese industry gained competitiveness in the world market. When the IMF regime of fixed exchange rates came to an end and was officially replaced by managed float in 1973, the Japanese economy had already been well industrialized and strong enough to withstand the wild swings in the yen’s value against the U.S. dollar.

In short, the Cold War and the original IMF system no doubt provided an externally favorable period for Japan to succeed in catching up with—and even surpassing in some industrial sectors—the West. The United States allowed—and even encouraged—Japan to pursue dirigiste development policy so that the latter would quickly reconstruct and strengthen its economy. In other words, Japan’s illiberal interventionist way of conducting economic affairs was tolerated, and some of its distinctive institutional arrangements such as the keiretsu formation, the main bank system, and company unions were actually promoted by the U.S. as instruments of quick economic recovery and political stability. No wonder, then, when the Berlin wall tumbled down, Chalmers Johnson aptly observed: “The Cold War is over; Japan has won.”

But towards the end of the Cold War (ever since President Nixon’s visit to China in 1972 and the subsequent start of China’s open-door policy), U.S. trade policy started to switch from unilateral free trade policy to reciprocity (the “level playing field” principle). This principle came to be even more emphasized after the collapse of the Soviet Union in 1989. For example, the United States initiated a series of bilateral trade negotiations with Japan, starting with the Market-Oriented Sector-Selective (MOSS) talks (1985-86 during the Reagan administration) and proceeding to the Structural Impediments Initiative (SII) talks (1989-90 during the Bush administration) and the Framework (or Bilateral Comprehensive Economic) talks (from 1993 onward under the Clinton administration) (Mikanagi, 1996; Choppa, 1997). The MOSS round signaled a shift of U.S. focus from restraining Japanese imports in the U.S. to opening up specific Japanese markets for American exports. In contrast, the SII talks involved economy-wide issues, such as macroeconomic policy (centered on savings and investment relationships which influence the trade balance), the distribution system, land policy, and keiretsu. Then, the Framework talks reverted to, and refocused on, the sector-specific approach by aiming at tangible results as “indicators” of market opening (Ozawa, 2001b).

The disappearance of communist threat with the demise of the Soviet empire in 1989 ushered the world decisively into a new era of U.S. economic diplomacy and dominance. The U.S. was no longer in need of placating its allies. It ever more strongly demanded reciprocity in openness for trade and investment. True, the September 11 attacks made America’s unilateralism moderate, but the success in the war against terrorism the U.S. has so far achieved in Afghanistan and elsewhere has fortified its resolve for “enduring freedom.” In his 2002 state-of-the-union message, President Bush called on the rest of the world to adopt the three tenets of market democracy: “open market,” “open trade,” and “open society.” These ideologies epitomize the nature of the outer set of global institutions and the driving forces of present-day globalization.

In the meanwhile, the international monetary system had already turned more market-coordinated with the adoption of managed float (i.e., flexible exchange rates) in 1973 after the abandonment of the Bretton Woods regime (i.e., fixed exchange rates) which required—and justified--state interventions to maintain fixed rates.

The Inner Set of Domestic Institutions in Evolution

Japan as a defeated nation began its reconstruction and modernization under the aegis of the United States. Japan’s political system in particular was overhauled so as to introduce democracy and to eliminate any feudalistic remnants of the prewar years. Most important of all, once communist threat emerged, a conservative government was quickly hand-picked by the United States. Nobusuke Kishi (who became a prime minister in 1957), a war criminal as minister of munitions in Tojo’s cabinet, was freed from war crime charge and released from prison, along with others. Many war-time economic planners, who once were engaged in the Greater East Asian Co-prosperity Sphere program, came back to Japan’s dirigiste bureaucracy and started to introduce a series of industrial policies. These postwar industrial policies have been well examined (inter alia, Patrick and Rosovsky, 1976; Komiya et al., 1988). The Japanese government, once granted independence under the San Francisco Peace Treaty of 1951, also began a so-called sengo kaikaku [postwar reforms] to create a new set of institutional arrangements, even revising some of the occupation-imposed measures such as the Anti-Trust Law.

New Structural Dualism

Blessed on the whole by favorable external market conditions and under its unique set of internal institutions, the Japanese economy has been successful in nurturing dynamic comparative advantages and climbing up the ladder of industrial upgrading. This has been accomplished by way of dynamic infant-industry protection (import-substitution-cum-export promotion), initially involving heavy protection of domestic industries. And only when Japanese enterprises became competitive, trade and investment barriers were gradually removed. In fact, the 1950s can be characterized largely as a period of strict import restrictions, the 1960s as a period of gradual liberalization, and the 1970s onwards as a period of more “committed” import liberalization (Ozawa, 1986). Although there was constant pressure from the United States on Japan to open up its market, Japan was on the whole allowed to schedule trade liberalization on its own terms. As pointed out earlier, as the Cold War intensified, the U.S. opted for a foreign policy in favor of security rather than of its own economic interests.

As explored elsewhere in terms of a flying-geese style (a la Akamatsu) structural upgrading (Ozawa, 1993), Japan started out with labor-intensive industries such as textiles, toys and sundries in the early postwar years (the “Heckscher-Ohlin” stage of growth). From there, Japan quickly developed competitiveness in a ladder-climbing fashion--first in steel, ships, and other heavy and chemical industries during the 1960s (the “non-differentiated Smithian” stage); in small compact automobiles and early-generation electronics (e.g., color TVs and calculators) during the 1970s (the “differentiated Smithian” stage); and in robotics, new materials, microchips, and luxury higher-end automobiles--and then on to latest-generation electronics (e.g., lap-top and palm-size computers, specialty chips, and play-stations) during the 1980s and through the mid-1990s (the “Schumpeterian” stage). Japan is now eagerly catching up in new Internet-driven industries (the “McLuhan” stage) (Ozawa, 2001b). And all these stage-delineated competitive industries have developed in, and come to constitute, what may be called the outer-focused (OF) sector, as shown in Figure 1.


During this course of structural transformation, it has transplanted overseas, notably in its neighboring Asian countries, via foreign direct investment those industrial activities and goods in which Japan lost competitiveness, as envisaged in a so-called “flying-geese” paradigm of comparative advantage recycling. This “industrial shedding” activity was instrumental in reallocating resources from comparatively disadvantaged to comparatively (actually also competitively) advantaged industries, raising overall industrial efficiency and productivity (Ozawa, 1993; 2001a).

In the meantime, however, Japan also has ended up creating a slew of once heavily regulated and protected inefficient industries—protected from competition, both domestic and foreign. Foreign competition in imports and inward FDI was fended off if not by outright legal restrictions but by the built-in bias of regulations and red tape. These industries, which is hereafter called the inner-dependent (ID) sector, are agriculture, forestry, fisheries, food and beverage, telecommunications, transportation, wholesaling and retailing, construction, health, banking, finance, insurance, real estate and other domestic-market-focused services.

These bifurcated sectors are under the jurisdiction of different government ministries. The OF sector has been mainly under the purview of the Ministry of International Trade and Industry (MITI)--whose name was changed to the Ministry of Economy, Trade and Industry (METI) in 2001. Because of its task of managing external diplomatic relations, the Ministry of Foreign Affairs (MFA) ought to be added as an indirect supporter—and beneficiary—of the OF sector. The ID sector, on the other hand, has been under the supervision of a variety of inner-focused ministries: The Ministry of Agriculture, Forestry, and Fisheries, the Ministry of Construction, the Ministry of Health and Welfare, the Ministry of Posts and Telecommunications, the Ministry of Finance, the Ministry of Labor, and the Ministry of Home Affairs.

It should be noted that these two structurally demarcated sectors which have come into existence are not totally separate entities but interconnected in a variety of ways. For example, the automobile industry is in the OF sector, but its distribution, auto finance, and some of its suppliers of inputs are in the ID sector. Japan’s car makers established their own networks of exclusive dealerships as well as their own multi-layered systems of parts suppliers. And there is little doubt that their tight controls on distribution has been one important hindrance to car imports. The similar situation exists in the consumer electrical and electronics goods sector. In other words, the keiretsu groups inevitably straddle both the OF and the ID sectors.

The government ministries have been the home of the interventionists promoting the development of domestic industries under their jurisdictions, thus continuing the bureaucratic tradition established by the Meiji government, Japan’s first modern administration, after the Meiji Restoration of 1868. As a latecomer nation, government ministries and agencies were created, as Johnson (1982) so aptly put, not so much as “civil servants” per se, as in the U.S., but rather as “task-oriented mobilization and development agencies” whose main functions were originally “to guide Japan’s rapid forced development in order to forestall incipient colonization by Western imperialists.” That is to say, their current predispositions toward controls are path-dependent—and justified from a nationalistic point of view.

As dynamic comparative advantages were acquired in the OF sector, Japan’s rising trade surplus began to cause a sharp appreciation of the yen and an ever-rising competitive pressure on the ID sector. The OF sector thus came to represent a competitive tradables sector, while the ID an ever protected and inefficient non-tradables sector.

Up until 1971, the yen was nominally fixed at Y360 to the dollar. This meant a continuous real depreciation (namely undervaluation) of the yen as Japanese industry gained export competitiveness. But once exchange rates were released to market forces, the yen quickly started its climb in appreciation. To cope with the ever-rising yen, the OF sector had to keep raising productivity to remain export competitiveness. As the sector succeeded in this endeavor, however, it again faced another round of yen appreciation because the ID sector did not absorb imports sufficiently enough to relieve the upward pressure on the currency. In other words, the OF sector came to be trapped in a treadmill: a vicious cycle from a struggle for productivity improvement and a greater trade surplus, to a higher-value yen, and to an even greater need for cost cutting.

The upshot was that over the 1973-1983 period, for example, labor productivity growth in Japan’s tradables sector outstripped that in the nontradables sector by as much as 73.2 per cent (compared to the U.S. tradables sector which exhibited a 13.2 percent higher productivity growth than in its nontradables sector) (Marston, 1987). And the yen began to exhibit the duplicity of being “strong externally but weak internally” because of its increasing undervaluation under the IMF regime of fixed exchange rates (until its collapse of 1971), which was further aggravated by the U.S. expansionary policy in pursuit of both the Vietnam war and the “Great Society” program.

The ID sector as the LDP “pork-barrel,” the Japanese Disease, and Hollowing-out

This intersectoral effect via the foreign exchange market is the Japanese version of the “Dutch disease” (Ozawa, 1997). Imports should have become available to Japanese consumers at cheaper and cheaper prices in yen terms, but they were either hindered by trade and inward FDI barriers or not delivered (passed through) at cheaper retail prices (i.e., the foreign exchange gains were simply pocketed by the highly regulated and protected distribution sector). In other words, a stronger yen was a hidden subsidy for the ID sector. And the OF sector began to escape from the disadvantages of producing at home by shifting production abroad via FDI. The high yen also subsidized this investment outflow. The upshot was a one-sided imbalance in Japan’s FDI account; a huge investment outflow but a miniscule investment inflow.

What made things worse was that instead of letting competitive forces rationalize the ID sector, the government held onto—and even reinforced through administrative guidance—its regulatory involvement to further shelter the ID sector. The reason was that this sector as a whole (but especially agriculture, construction, distribution, and finance) was the key political power base and financial source of the Liberal Democratic Party (LDP), Japan’s long-reining political regime ever since 1955. In this respect, the ID sector can be most appropriately identified as a “pork-barrel sector,” a political economy institution developed basically as a legacy of the occupation authorities.

This characteristic is most pronounced particularly in agriculture, construction, and chuso-kigyo [small and medium businesses]. Early on (for example, in 1955), agriculture was the major political base of the LDP when that sector employed provided employment for as much as 39 per cent of Japan’s work force and yielded 21 per cent of its GDP (Argy and Stein, 1997). In fact, this pork-barrel was created as a result of a drastic land reform introduced by the occupation authorities (the U.S.) to emancipate peasants. Under this reform, up to 1950, about 1.5 million landlords lost their farmland (except about five hectors for their own use), while about 4 million peasant households acquired new land (Nakamura, 1994; Takahashi, 1968). Consequently, the tenant farmers all but disappeared. Reportedly, General MacArthur observed “no surer foundation would be found on which to construct a sound and moderate democracy, and no more trustworthy defense against the pressure of extreme ideologies [such as communism and totalitarianism]” (cited in Takahashi, 1968, p. 129). MacArthur also converted the prewar and wartime hierarchy of agricultural associations into a democratic agricultural cooperative system. These well-organized agricultural cooperatives became a powerful political lobbying bloc on par with other lobbying groups such as labor unions and Japanese Medical Association.

Thus, agricultural regions themselves, along with their surrounding semi-urban farm-linked areas (where farm-related activities such as dairy, food processing, farm supplies and services are centered), became a major political power base for the LDP. In fact, these farm districts came to be overrepresented for electoral voting. “Although eligible voters in the agricultural sector made up around only around 20 percent of the national electorate in 1976, the rural and semiurban districtrs in Japan decided about 30 percent of the seats in the Lower House of parliament” (Okimoto, 1989, p. 183).

Throughout Japan, but especially in the urban districts, construction firms and their workers (estimated to be over 6 million workers, approximately about 10 per cent of Japan’s labor force) have also been staunch supporters of the LDP.

Beside contributing to leading politicians who throw business their way the [construction] companies hire senior officials from the central government and from larger subnational jurisdictions and public corporations that are responsible for serious amounts of construction orders [i.e., amakudari or “descent from heaven”] … Japan is a construction state, in contrast to being a military-industrial state or a welfare state. The circular flow is from taxpayers to construction companies for massive development projects, bridges and tunnels, highways, and airports. The money goes to favored construction companies, who provide kickbacks from these regional development projects, to the LDP politicians who keep the money flowing (Tabb, 1995: pp. 172-3).
In addition, small businesses in both manufacturing and distributing (wholesale and retail) constitute an important political base for the LDP, as Japan’s primary sector contracted while the secondary and tertiary sectors expanded--pari passu with rapid economic growth. Wholesale and retail businesses (including restaurants) have been squarely in the highly protected and regulated ID sector. In short, it is thus important to realize how the ID sector was built up as the pork-barrel of LDP politicians, many of whom are popularly identified as a “farm tribe,” a “construction tribe,” a “road tribe,” and so on as they represent their particular constituencies.

Liberalization, the Bubble, and its Aftermath

As repeatedly—but so far to little avail—called for by Junichiro Koizumi, supposedly a marveric prime minister, Japan is in dire need of reform. The reforms required can be classified broadly into two types: the public-domain type and the private-sector type. The former includes a budgetary reform, the privatization of the postal saving system, the elimination or privatization of “special public corporations” whose existence is only for the purpose of providing post-retirement plums for high-ranked bureaucrats, and a host of deregulations designed to increase competition, especially in the hitherto sheltered ID sector. The private-sector type involves, for example, a quick disposal of non-performing bank loans, a swift restructuring of corporations (via discarding unprofitable business units) and a switch from seniority to a merit-based system of wages and promotion inside companies. Needless to say, the public-domain reforms are prerequisites or simultaneously needed to promote/induce the private-sector reforms.

All these recognized needs for reform stem from the fact the postwar system which once did the wonders for Japan’s phenomenal catch-up growth is no longer in sync with the drastically altered economic conditions/environs, both inside and outside Japan—the conditions such a system itself contributed to its alterations. In other words, the principle of institutional incongruity set in.

The OF-ID dual structure was also responsible for the ballooning and burst of the asset bubble (1987-1990). As is well known, Japan’s high growth (1950-1974) was financed mostly by bank loans under the so-called “main bank” scheme, although the stock market initially was a relatively important source of funds for corporate investment but came to be overwhelmed by bank loans.4 Under central bank-based finance, the Bank of Japan pumped reserves into the six major city banks, which in turn extended industrial loans to their own groups of closely affiliated corporations, the six groups know as the bank-led kinyu keiretsu (financial conglomerates).5

Ironically, however, the main bank system has proved to be self-destructive; the more effective it was in facilitating Japan’s catch-up industrialization in heavy and chemical industries during the high-growth period by way of subsidized capital infusion, the faster its loss of effectiveness. The process of globalization (that is, inevitable deregulations Japan had to implement in its financial sector) accelerated this paradoxical outcome.

A number of developments quickly unfolded (Ozawa, 2001a):

(i) Thanks to the low-cost capital made available under the main bank system, large-sized firms, especially those in the keiretsu groups in the OF sector, began to grow and accumulated internal reserves very rapidly. This accumulation of retained earnings made the banks’ clients less dependent on loans. At the same time, as Japan left behind the stage of heavy and chemical industrialization and moved up the next stage of assembly-based, more consumer-oriented industries (notably cars and electronics), there soon merged new word-class manufacturers (such as Toyota, Honda, Sony, and Matsushita just to name a few). These were Japan’s new maverick companies which began actively to issue new stocks at market prices, breaking the keiretsu-pleasing custom of issuing new equities at par value on a pre-emptive basis. These successful Japanese corporations were also soon able to tap the international capital markets for their financing needs at lower costs as restrictions on borrowings from abroad were lifted with the amendment of the Foreign Exchange Control Law in 1980.

(ii) Consequently, the banks began to lose major customers for lending. The popular phrase “ginko banare [departure from banks]” came to describe this phenomenon. Having been used as the key policy instrument of bank loan capitalism, however, the banks still felt protected by the government and guaranteed for bailout if anything went wrong. In fact, the Ministry of Finance itself publicly assured that no bank would be allowed to fail.6

(iii) It was against this backdrop that banks’ imprudent lending resulted in a short-lived bubble in Japan over 1986-90. The Plaza accord of 1985 soon drove up the yen phenomenally. Fearing a “high-yen” recession, the Bank of Japan pumped money into the economy. This made the banks awash in liquidity. Having lost many large borrowers, they had to look for new, smaller, more risky borrowers. The banks found small- and medium-sized enterprises, real estate firms, construction companies, and finance firms in the ID sector as their new customers. In particular, they channeled loans through non-bank banks (that is, housing loan companies and consumer credit firms), since the latter were less strictly regulated than the banks themselves.

Low interest rates and the abundance of liquidity fuelled the rising prices of stocks and real estate. Many Japanese firms issued new shares at home and bonds (including so-called “warrants”) overseas, but actively put the proceeds back into the stock market, driving share prices even higher. This speculative mania was even lauded as zai-tekku [financial engineering]. The banks became all the more anxious to lend to anyone, especially those who had land, since the value of land as collateral soared due to speculation. The rising stock prices in banks’ portfolios increased their capacity to make even more loans. Thus, a speculative spiral was set in. The bubble was nothing but the outcome of the main bank system gone astray.

(iv) The bursting of the bubble began in early 1990, following the rise in the discount rate. The stock market topped out on the last trading day in 1989, and the urban land price started to fall shortly later. The debacle was a disaster for borrowers in real estate, construction, distribution, and finance, as well as for banks as lenders—all in the ID’s pork-barrel sector. The banks thus came to be saddled with the ever-rising amounts of bad loans (most recently estimated somewhere between $338 billion (“nonperforming” loans only) and $1.23 trillion (inclusive of “problem” loans as of April 2001).

In sum, the bubble was created largely in the ID sector into which the banks poured liquidity since they were no longer the critical source of corporate fund in the OF sector. True, the ID sector has done its job in supporting and keeping Japan’s pro-business party in power, thereby enabling Japan to achieve its dream of catching up with the West and joining the ranks of the most advanced. But the very institutional setup of dualism eventually culminated in a devastating economic downturn.

Why are They so Indecisive in Cleaning up the Banking Mess?

Everybody knows that the core of the current Japanese doldrums is Japan’s troubled banking industry which is most severely victimized by the vicious circle of “triple deflation” (simultaneous declines in the prices of goods, property, and equity shares).

As a legacy of the main bank system, the banks still hold a large amount of shares of their customers. True, this cross-shareholdings have recently somewhat declined, but this

“dishoarding” process has a long way to go, since nearly two-thirds of Japan’s total

outstanding stocks are still held by financial institutions. Hence, the swooned stock prices reduced their lending capability, especially under the Basel Accord which imposed the 8 percent capital requirement for risk-weighted assets.

As already discussed above, forcing the banks to abruptly reduce problem loans (estimated to be over $1 trillion) means the bankruptcies of an enormously large number of heavily indebted companies, the companies in construction, distribution, and small businesses—all in the LDP’s pork-barrel sector. It is a political suicide. They cannot bear a cold-turkey treatment of the type the United States successfully used to solve the U.S. savings-and-loan crisis of the 1980s. Hence, the government keeps propping up the banks, which in turn prop up their customers.

International Business (inward FDI and New Economy) to the Rescue

While the government muddles on, there have occurred some promising developments. Ironically, the very external market forces Japan has long endeavored to suppress and control are now coming to the rescue of Japan in carrying out major reforms—without much fanfare. Although the process is a gradual one that has been momentarily hampered by the recent slump in the U.S. economy, dramatic changes are in motion, creating promising roles and opportunities for foreign investors as well as potential for Japan to realize a new economic vitality (Ozawa, 2001c).

Beginning in the latter half of the 1990s, signs of fundamental change increased—with the collapse of the ID sector. Yamaichi Securities, Japan’s oldest such firm (bankrupted in 1997), was sold to Merrill Lynch. And in 1999, the Long-Term Credit Bank of Japan, one of Japan’s three major quasi-public institutions designed to provide long-term capital to infrastructure projects throughout Japan’s high growth period (1950-1973), was bought by Ripplewood Holdings (U.S.) and was renamed the Shinsei Bank. Japanese companies were in dire financial straits, and only foreign companies had expressed interest in acquiring the Long-Term Credit Bank. Politically, the American side treated these deals as examples of Japan’s sincerity about opening its financial markets to foreign participation under the program of financial deregulation referred to as the “Big Bang.”

Second-tier Kofuku Bank and Tokyo Sowa Bank were also quickly purchased by a Texas-based equity fund, Lone Star. Two of Japan’s mid-size consumer finance companies fell into the hands of AFCC (a subsidiary of Citigroup, U.S.). Foreign investors from France, Switzerland, and the U.S. also had a field day, as they bought up six of Japan’s troubled insurance companies.

In 1999, Renault of France took a 36.8 percent stake in and assumed the management of Nissan Motor Company, Japan’s number-two automaker. The company began an impressive turnaround under the French executive Carlos Ghosn, who is popularly known in Japan as “le cost cutter.” Only a few years before, who would have imagined that this world class Japanese car maker—whose vehicles were rated higher in quality, reliability, emissions control, and fuel efficiency than any Western-made car—would have to be rescued by French management?

But the once-touted Japanese-style management quickly lost its luster. Those Japanese companies with excess capacities were simply unable to restructure. Japanese management was not prepared to retrench through ruthless, Western-style cost-cutting measures that would throw tens of thousands of workers out of their jobs. French management, however, quickly moved to reduce Nissan’s global workforce, to close excess assembly plants and drop its inefficient suppliers. Similar restructuring efforts are under way at all other Japanese automobile makers that are controlled by foreign multinationals, including Mazda, Mitsubishi, and Fuji Heavy Industries. It is indeed a sea change, now that Prime Minister Koizumi specifically has endorsed Renault’s takeover and impressive turnaround of Nissan as an exemplary way of restructuring Japanese businesses in this age of globalization.

Japan’s distribution sector (wholesaling and retailing)—once off-limits under the Large-Scale Retail Law that protected small, mom-and-pop stores in the ID pork-barrel sector—is now being crowded in by a number of large-scale distributors and retail stores. While competition comes from both domestic and foreign sources, it is particularly been from foreign multinational discount chains, such as Toys`R’Us, Office Depot, The Gap, Boots, Sephora, Starbucks, Carrefour, and Costco Wholesale.

Japan’s telecommunications industry, only recently deregulated, has quickly attracted Vodafone Group and British Telecommunications (both of the U.K.) as new shareholders in J-Phone Group, one of Japan’s three major wireless phone companies.

The suddenly rising FDI in Japan is boosting the presence of foreign business interests. They now form an increasingly effective lobbying group that is pressuing the Japanese government to create a more business-friendly environment through deregulation and by rewriting Japan’s archaic commercial codes. It is no coincidence that Howard Baker, the U.S. ambassador to Japan, called for U.S. opportunities to invest in Japan that would be comparable to Japan’s freedom to invest in the United States.

Business restructuring requires the disposal of nonprofitable businesses in the M&As.

The recent corporate tax reform is a welcome development, since it enables companies to reorganize around their holding companies by way of either “spinning-off’ or “spinning-in,” as illustrated in Figure 2. Holding companies are thus now increasingly used to spin off and separate unprofitable business units (e.g., divisions, departments and subsidies) from profitable ones so that not only are the tax advantages to be gained but also the noncompetitive units can be disposed of in the M&As market. At the same time, they allow specialized companies to diversify their business activities by acquiring new businesses.


Japan’s sudden opening to inward FDI is well reflected in the value of such investments. Inward FDI in 1998 ($10.47 billion) was nearly double that in 1997 ($5.53 billion). And it further rose to $21.5 billion in 1999, doubling again over the previous year (JETRO, 2001). The figure for 2000 is estimated to be over $33 billion. True, Japan’s cumulative outward-inward FDI ratio is still high, as high as 5.4 in 1999—much higher than Germany’s 2.8 in 1997, Britain’s 1.4 in 1998, France’s 1.2 in 1998, and U.S.’s 0.9 in 1998 (JETRO, 2001). But Japan’s willingness to host foreign multinationals has vastly risen in the space of a few years, especially in the ID sector. And inward M&As have likewise jumped. The total number of cases, for example, stood at 36 in 1997, but rose to 54 in 1998, to 104 in 1999, and to 112 during the first three quarters of 2000 (JETRO, 2001).

What is more, the advent of the IT revolution has thrust Japan abruptly into a new stage of growth that intensively employs IT and intellectual capital. An IT-driven economy is a creature of America’s free-market system and its equally freewheeling equity market. It is a long-term outcome of deregulation, trade liberalization, a flexible labor market, and coalescing technological changes. It took the United States about two decades to establish an IT-driven economy. In particular, capital markets (venture capital, equities, IPOs, and mergers and acquisitions) have been an indispensable ingredient of the unprecedented U.S. economic boom. Because the IT revolution emerged as a result of drastic deregulation and free-market play in the United States, its spread to Japan has already significantly affected Japan’s system, especially in the areas of telecommunications, finance, and distribution. Along with FDI in Japan, the IT revolution is providing an autonomous, market-driven impetus for Japan to deregulate its business milieu so as to promote entrepreneurial Internet ventures.

One prime example of this process is Japan’s burgeoning cell phone (wireless telecom) market, which now boasts the world’s largest number of subscribers to NTT DoCoMo’s wireless Net access service (popularly known as “i-mode,” the world’s most advanced mobile data service). This domestic advantage gives Japan a head start in the race to introduce third-generation (3G) cellular service.

A surprising little-known fact, however, is that the United States forced Japan to deregulate its mobile phone market in 1994 to support the expansion American telecom multinationals into the Japanese market. Motorola was once an early innovator in mobile phones. Until then, Japanese citizens were not even permitted to own personal cellular phones. Thanks to the U.S. pressure to deregulate, Japan finally opened up this market and serendipitously leapfrogged to the forefront in the global race to a wireless Internet.

Japan has long been known as a skilled emulator, as demonstrated by its successful industrial restructuring in the past. Now, the advent of the Net age is providing another unique opportunity to catch up. Sensing the opportunity, Japan has again begun to mobilize itself. In September 2000, its newly formed twenty member Information Technology Strategy Council, chaired by Sony’s president and composed of other notable captains of industry such as Toyota Motor Corporation, Softbank, and IBM (Japan), announced an ambitious goal: to overtake and surpass the United States in the Internet economy in five years. To this end, the Council urged the government to dismantle all institutional obstacles to the growth of a New Economy (i.e., burdensome regulations). Japan has a solid production base of Internet components, including telecom equipment, fiber optics, and digital goods. Another round of catch-up is in the making.

Summing Up

The Japanese experience provides a fascinating case study on the interactions between the outer set of evolving global institutions and the inner set of domestic setups. Early postwar Japan was skillful in setting up a unique matrix of domestic institutions designed to facilitate its catch-up growth under the leadership of a pro-business political party, the LDP. The party’s power was built on a large segment of voters and campaign fund contributors in the ID industries such as agriculture, construction, distribution, and small businesses, which have long been sheltered from competition, especially competition from foreign multinationals’ FDI. Yet, with the successful growth of the OF sector, there has emerged a dual industrial structure, which was in large measure responsible for the bubble of 1987-1990 and its aftermath, the present banking crisis. And herein lies the inability of the currently ruling LDP to adopt a cold-turkey treatment to cure the bad loan problem; it would be politically suicidal to do so.

Yet the Japanese government and industry have begun to welcome and host foreign multinationals’ participation in local businesses earnestly for the first time since the end of the Second World War. Indeed, this new open-door policy is referred to as the “third opening of Japan.” It follows two other major transformations, the Meiji opening of 1868 and the postwar opening of 1945. These past openings were driven by external pressures, and the current third opening continues this pattern. In other words, the inter set of institutions is compelled to adapt to, and adopt the norms of the outer set of institutions and the forces of globalization. But the difference is that this new movement toward economic liberalization has been fundamentally compelled by market forces rather than led by the government.

Two key market imperatives have been forcing Japan to bring itself more in line with the outer set of institutions. The first is corporate Japan’s pressing need to dispose of excess capacities and distressed businesses while acquiring new managerial skills and expertise in business restructuring. The second is the advent of the IT revolution, which calls for deregulation and a more market-oriented milieu, where entrepreneurship, with its free-spirited ideas, can flourish. Thus, these market imperatives are engendered by international business activities and competitions. In the past, Japan has excelled in innovating new technologies and business practices. These alone are not enough to cope with the present crisis. Japan is now groping for new and better institutions, which can replace or renovate the now obsolescent inner set which was established many decades (a half century) ago and has been ossified to the detriment of the present Japanese economy.

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Figure 2. Corporate tax reform and business restructuring

A. “Spinning-off” approach

Diversified/integrated Holding company

corporation Sales Opportunities

for M&As

Divisions/departments Subsidies


B. “Spinning-in” approach

Specialized corporation Holding company

Purchase opportunities

for M&As



3 As Tsuru (1993: 38-38) put it, “The first part [of the six-and-eight-months of American occupation] was epitomized by a typical statement by the Joint Chiefs of Staff to the effect that `the plight of Japan is the direct outcome of its own behavior and the Allies will not undertake the burden of repairing the damage,’ … The second sub-period was characterized, on the other hand, by the U.S. determination to restore Japan’s prewar position as the “workshop of Asia” and to preserve her economy as far as possible from socialist encroachments.”

42. In order to control credit expansion, the government early on prohibited corporations from issuing bonds. A bond-issuing privilege was granted only to those financial institutions (mainly, three long-term credit banks) and utilities that were specifically designed to finance public purpose long-term project (Patrick, 1994).

53. These keiretsu groups were led by their major banks (the Mitsui Bank, the Mitsubishi Bank, the Sumitomo Bank, the Fuji Bank, the Sanwa Bank and the Dai-Ichi Kangyo Bank).

66. Until the failure of Hanwa Bank in November 1996, a mid-sized regional bank, no Japanese bank had ever gone out of business since the Second World War. Even faltering banks were protected under the so-called “goso sendan [convoy]” policy, which compelled stronger banks to help out weaker ones.

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